In this Oct. 23, 2003 file photo, Gov.-elect Arnold Schwarzenegger, left, and Gov. Gray Davis joke with each other as Davis shows Schwarzenegger the governor’s private office at the Capitol in Sacramento.

Remember 2003? Gray Davis was recalled, porn stars ran for governor, Arnold Schwarzenegger catapulted into office — and California’s state and, for the last time in many, many years, local governments paid more into their pension plans than they owed in outstanding pension debt.

In those halcyon days, your cities, state and local governments paid $7 billion to support their workers’ golden years, while the gap between what they owed those workers — and what they actually had squirreled away — was just a wee $6 billion, according to figures from the State Controller’s Office.

One year later — the year Ronald Reagan died, John Kerry faced off against George W. Bush, “The Lord of the Rings: The Return of the King” won 11 Oscars and newly-sweetened public employee retirement formulas kicked in in earnest — the gap between what California governments had on hand what they owed workers exploded to $50.9 billion.

And so it went. Each year, state and local governments shoveled more and more cash into pension funds — $16 billion, $19 billion, $21 billion — but each year, the growth of their “unfunded pension liabilities,” as it’s called in government-speak, continued at a monstrous rate nonetheless — to $64 billion, $128 billion, $241 billion.

Then — hallelujah! — the hole shrank a tad in 2015, dipping to $234 billion.

Did California turn the corner?

Unlikely, experts say. That dip was the work of some stellar years on the stock market — the mammoth California Public Employees’ Retirement System clocked returns of 13.2 percent in 2012-13, and 18.4 percent in 2013-14 — mixed with a brew of overly-optimistic expectations on investment returns and less-than-realistic assumptions on how long retirees will live, among other things, which will soon be sobering up in such a way that the unfunded figures will grow even more.

Even at that lower figure, unfunded liabilities can be viewed as a $6,000 debt for every man, woman and child in the state of California.

Why should you care? Because it’s your pocketbook. If that hole is not filled up with meatier earnings and heftier contributions from public workers and agencies, taxpayers could be called upon to fill it directly.

This is where folks start talking about heady concepts like “generational equity.” Your children and grandchildren will be paying for the services that you are enjoying today. And there’s also the concept of “crowd-out;” as governments pay more into pension funds there is less available for services like roads and parks and libraries. They ask: Is that fair?

There are basically two things that can happen next: Workers and governments negotiate more modest benefits for work yet to be performed, or taxes go up.

The smart money is on some combination of the two, and the California Supreme Court may make a game-changing decision on all that soon.

California has long considered public pension promises as contracts etched in stone — i.e., the formulas in place on the first day of a worker’s employment can never, ever be changed, and any attempts to do so violate the California constitution. But state appellate courts have concluded that governments do, indeed, have wiggle room:

“While a public employee does have a ‘vested right’ to a pension, that right is only to a ‘reasonable’ pension — not an immutable entitlement to the most optimal formula of calculating the pension,” wrote Justice James Richman in a ruling regarding Marin County last year. “And the Legislature may, prior to the employee’s retirement, alter the formula, thereby reducing the anticipated pension. So long as the Legislature’s modifications do not deprive the employee of a ‘reasonable’ pension, there is no constitutional violation,”

The California Supreme Court has agreed to hear this, and similar cases. It’s unclear if it will agree.

Bear wrestling

Officials from retirement systems say they’ll be able to hold the line on the growth of unfunded liabilities and eventually catch up without changing the formulas. Observers remain skeptical.

“The economic downturn and the volatility in the market were still the primary drivers for CalPERS unfunded liability growth during this time period,” CalPERS spokeswoman Amy Morgan said after reviewing our numbers. “Our strong investment returns in fiscal year 2013-14 of 18.4 percent and pension reform savings helped offset the unfunded liabilities increase from growing significantly.”

Many agencies in California are trying to attack the problem by paying down their unfunded liabilities earlier and kicking in more than the minimum-required annual contribution, she said. The state will pay an extra $6 billion this year to fill its hole, which should save $11 billion over the next 20 years, Morgan said. In the last fiscal year, more than 150 agencies did much the same thing.

“CalPERS estimates that our unfunded liabilities are expected to decrease over time and not increase unless there is a string of losses,” she said.

Tom Aaron, vice president and senior analyst at Moody’s Investors Service, expects to see much the opposite, at least for a while.

“Something we’ve seen on a widespread basis in the past year or two is that public pension plans have reduced their assumed rates of return,” Aaron said. “Not long ago, CalPERS had assumed returns of more than 8 percent, but recently decided to drop that down to 7 percent. That results in liabilities going up.”

Even when systems hit targeted returns — and they exceeded those targets this year — the amount that governments and workers kick in isn’t enough to prevent unfunded liabilities from growing, he said. They tend to favor paying less now and paying more later, robbing them of the magic of compounding.

There is not a pension fund in America that can earn its way out of its liabilities, said Peter Kiernan, public finance specialist and chair of the New York State Law Revision Commission. Lost compounding is the primary reason.

Money makes money

Compounding, Mary Mary Quite Contrary, is how the money garden grows.

If you put $100 away today and earn 5 percent interest, viola! Next year you’ll have $105 to earn 5 percent interest, and so on. Money makes money. Exponential growth.

But, if you put $100 away today and lost money, not only is your principal gone, but the interest earnings you were counting on to pile up and earn even more interest are gone as well. Dramatic events, like the financial meltdown of 2008, wiped out billions from public pension funds — including nearly one-quarter of what was in the coffers of the CalPERS. That makes it very hard to regain lost ground.

There are larger changes at work: Forty years ago, contributions from governments and workers comprised two-thirds of what was in the pension funds, and one-third was expected from investments, Kiernan said. Today — driven by the bull markets of the 1980s and ’90s — it’s just the opposite.

Annual required contributions have more than doubled over last decade, from 6.2 percent to 18.1 percent, which leaves less money to pay for other things.

State Sen. John Moorlach, who had been warning that the current system is unsustainable for years before the issue pierced the popular consciousness. The spike in liabilities seen between 2003 and 2004 was the work of new, more generous, retroactive retirement formulas adopted by one public agency after another in the early 2000s.

Meaning this: City A had been socking money away for Police Officer B’s retirement for decades. When City A adopted sweetened pension formulas, it suddenly was committed to paying Police Officer B quite a bit more every month for the rest of his life — even though it had never set money aside to cover a pension that large.

Officials thought pensions were so super-funded that this retroactive thing would not come back to bite them. Add in “pension holidays” (when funds looked so healthy that officials quit putting money into them, sometimes for years), a crippling recession, lengthening life spans, a spike in retirements and reductions in what pension plans expect to earn on investments, and you get a hole hundreds of billions of dollars deep.

What’s next?

Or deeper. Current liability totals are computed assuming returns on investments that exceed 7 percent, which critics say won’t pan out over the long haul.

If one assumes lower return rates — as does former Democratic Assemblyman Joe Nation, now of the Stanford Institute for Economic Policy Research, on Stanford’s Pension Tracker — the hole can easily double, triple or quadruple.

But the end is not nigh, said Kiernan.

“California’s pension systems are underfunded significantly, but they are not in a death spiral,” he said. “An effort is being made to achieve reform and enhance funding. A good investment year easily could be followed by a bad one and there could be regression, however. It just is too early for gloom and doom.”

There must be political bargaining, he said. Since the recession, every state has tried to adopt reforms — but those modest formulas apply only to new hires, doing little to nothing to reduce current liabilities for the vast universe of public workers.

We invited several public pension advocates to share their thoughts on the numbers. They said they were studying them, but did not respond by deadline.

“The relevant question to ask is: Is there sufficient political will to achieve major reform?” Kiernan asked.

Sforza birthed the Watchdog column for The Orange County Register in 2008, aiming to keep a critical (but good-humored) eye on governments and nonprofits, large and small. It won first place for public service reporting from the California Newspaper Publishers Association in 2010. Sforza contributed to the OCR's Pulitzer Prize-winning investigation of fertility fraud at UC Irvine, covered what was then the largest municipal bankruptcy in America‘s history, and is the author of "The Strangest Song," the first book to tell the story of a genetic condition called Williams syndrome and the extraordinary musicality of many of the people who have it. She earned her M.F.A. from UCLA's School of Theater, Film and Television, and enjoys making documentaries, including the OCR's first: "The Boy Monk," a story that was also told as a series in print. Watchdogs need help: Point us to documents that can help tell stories that need to be told, and we'll do the rest. Send tips to watchdog@ocregister.com.

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